The Risk of “Phantom Income” as a Small Business Owner

Phantom income occurs when there is revenue that is reported to the IRS by an entity for tax purposes, but the entity or the individual never actually receives any income. For “pass-through” entities, where income and subsequent losses are passed through to the owners of the company (as opposed to the entity itself), this poses potential problems for business owners and silent investors. Such pass-through entities where taxes do not need to be filed for the entity itself, including partnerships, LLCs (at least those not taxed as corporation), and S-Corporations, these risks can arise. Alternatively, traditional C-Corporations are taxed at the entity-level and shareholders pay tax on distributions are actually made.

In a simple Partnership or LLC, phantom income may occur when the entity has taxable income for a given fiscal year (let’s say $300,000), but that income is reinvested back into – or retained by – the company, as opposed to each owner taking their ‘share of the profits’. For these pass-through tax entities, all the taxable income generated by the entity is attributed to the business owners on a K-1 form relative to each owner’s percentage of ownership – even if the funds are not actually distributed.

Accordingly, although the company may distribute zero funds to the owners, those owners are still on the hook for their share of the taxes. Using the same $300,000 income for an LLC as an example, if an owner has a 50% stake in the LLC, they would be on the hook for the taxes due on $150,000 in taxable income (which could be a tax bill of $25,000), despite never receiving any distributions themselves as income. We call this “Phantom Income”.

What should you be looking out for, either as a small business owner, investor, or silent partner? We advise our clients to include a ‘Tax Distribution Clause’ (or similar type of clause) in partnership agreements, bylaws and LLC Operating Agreements. These clauses require the entity itself to estimate the amount of tax each shareholder is obligated to pay on the ‘phantom income’, and to then pay that amount of tax to the shareholder to cover the tax liability. This may be done on a quarterly or annual basis, but it ensures that investors and shareholders, minority or not, are not left to deal with a surprisingly high tax bill when tax season rolls around.

The type of entity you choose to form is an important decision – choosing wisely and understanding the pros and cons can give, and engaging an experienced attorney to draft the operative documents – can give you peace of mind. If you plan to form a new business or register an existing business, contact Boston Business Lawyers at The Jacobs Law LLC today at 1-800-652-4783 or email us at ContactUs@TheJacobsLaw.com

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